Previously on MoreLiver’s:
Special: German Elections 2013 (updated)
Credit - The Cantillon Effects
"Labour was the first price, the original purchase - money that was
paid for all things. It was not by gold or by silver, but by labour,
that all wealth of the world was originally purchased."- Adam Smith
Last week, we concluded our post by indicating of one of our "outside
the box indicator" namely Sotheby's stock price versus world PMIs since
2007 - graph source Bloomberg:
We argued that the performance of Sotheby’s, the world’s biggest
publicly traded auction house was indeed a good leading indicator and
has led many global market crises by three-to-six months.
Of course, our reference to this "outside the box" relationship was by
no mean "innocent". In fact it was the perfect way for us to justify
this week's chosen title given that "Cantillon effects" describe
increasing asset prices (asset bubbles) coinciding with an increasing
"exogenous" (central bank) money supply.
So why choosing art as a reference market in describing Cantillon effects and asset bubbles you might rightly ask?
Well, as posited by a very interesting study by Cameron Weber, a PhD
Student in Economics and Historical Studies at the New School for Social
Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an
effective means to measure Cantillon Effects as art is removed from the
capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.
In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.
Economic theory is that as money supply increases, the “time-preferences” of art investors decreases
(art becomes cheaper relative to consumption goods) and/or inflationary
expectations mean that art investors see price signals (“easy money”)
encouraging investment in art." - Cameron Weber, PHD Student.
Nota bene: Classical equation of exchange, MV = PQ, also known as the
quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real
GDP, P = inflation/deflation, M = money supply, and V = velocity of
money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)
In our Cantillon Effects, we get:
Δ M => Δ Asset Prices
Our friend Cullen Roche recently argued that the "Austrian
Business Cycle Theory is inherently flawed and built on
misunderstandings about the way the modern monetary system actually
works.":
"Austrian Business Cycle Theory Misunderstands Endogenous Money.
Like many other economic schools of thought, Austrian economics is
predicated on a loanable funds model with a world view designed to
demonize just about everything the central bank does. As I’ve explained
before, the primary purpose of the central bank is not a conspiratorial
attempt to enrich bankers, but to help oversee and regulate the smooth
functioning of the payments system." - Cullen Roche
As far as we are concerned, if economy is a "religion" then we are
agnostic, but, we do believe that, there are some points which are valid
in some theories, Austrians included.
By no mean, we would like to enter into endless economic arguments. We have no point to prove, just common sense to display.
Our objective in this week's
conversation, is rather to expand our vision (and maybe yours) to our
understanding of "Cantillon effects", asset prices bubbles and
"mis-behaviors" of markets (in true Mandelbrot fashion that is...).
"Cantillon effects" in the market for art:
"Money supply is “M1” based on methodology used by Bessler 1984 and
Devadoss & Meyers 1987, in order to compare results of Cantillon
Effects versus money supply effects on output prices.
Art data based on 1,336 repeated sales from 1830 – 2007 on the London market.
Data provided by Goetzmann et al 2010, data
commonly used by cultural economists to measure returns to art versus
other assets, updated by Goetzmann et al for error correction,
contemporary art (1960s onward) and a more recent method for inflation
indexing.
We find two distinct periods of monetary history, leading to the need
for data bifurcation between the pre-war Classical Gold Standard (1830 –
1913) and the post-war central-banking era (1946 - 2007)."
- source Cameron Weber, PhD Student in Economics and Historical Studies.
From the same study from Cameron Weber we learn the following interesting point:
"Bessler 1984 and Devadoss & Meyers 1987 use a VAR log likelihood
model to estimate the most likely lagtimes between a monetary change
and effects on output prices. They find (using monthly data) that the
most likely lagtime is 13 and 14 months with a rapidly dissipation of
the price increase immediately following the most likely effect.
Using the same methodology we find that the most likely effect of a
money supply change on art prices is also between the 13th and 23rd
month (e.g., during the 2nd year using yearly data).
However, unlike the earlier work on output prices, we
find that the effect on art prices does not decay rapidly after the
monetary increase, showing perhaps that money changes are cumulative
(and/or have momentum) and could lead to an ‘asset bubble’." - source Cameron Weber, PhD Student in Economics and Historical Studies.
The most interesting part of using the art market as a "proxy" for asset
bubbles is indeed that money changes (namely the monetary base) leads
to the creation of "asset bubbles".
"Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game." - source Macronomics.
And as we posited in our January conversation "If at first you don't succeed...":
"Arguably the strategy of our "Sorcerer's apprentice" has been to try to induce a rise in velocity, but, we have shown in our post "Zemblanity" that the
"relationship" between US Velocity M2 index and US labor participation
rate over the years is clearly indicative of the failure of the theories
of Friedman and Keynes because
central banks have not kept an eye on asset bubbles and the growth of
credit and do not seem to fully grasp the core concept of "stocks"
versus "flows." - source Macronomics
Another
illustration of the cumulative effect in the change of money leading to
asset bubble has been clearly illustrated by the housing bubble leading
to the financial crisis given we are now at the 5 year anniversary
mark.
Once again "Cantillon effects" were at play as clearly demonstrated by Cameron M Weber, Cameron Weber, a PhD Student in Economics and Historical Studies, in the following abstract - "The Economic History of the Recent Financial Crisis Using Cantillon and Intervention Effects as a Basis for Explanation":
"This research uses Cantillon effects
and institutional, policy, incentives created in the market for home
purchases in the US to show correlation and causation between an
increase in the quantity of money and an increase in home prices during
the housing “boom” and the subsequent financial collapse based on the
“bust” of the housing boom. Initial results
show that the FHA policy initiated in 1998 to encourage 0% down-payment
mortgages for housing triggered a relationship between an exponential
growth in housing prices with that of an exponential increase in the
money supply. Initial results also show that this structural
relationship ended in May 2006 when the SEC declared “accounting
irregularities” at Fannie Mae, which also coincides with the downturn in
housing prices." - source Cameron Weber.
When it comes to the current market
conditions and "Cantillon Effects", and asset bubbles, as well as other
valid economic theories, Keynes coined the term "Animal spirits" in his
1936 book "The General Theory of Employment, Interest and Money" to
describe the instincts, proclivities and emotions that influence human
behavior, consumer confidence, as well as speculation:
"Even
apart from the instability due to speculation, there is the instability
due to the characteristic of human nature that a large proportion of
our positive activities depend on spontaneous optimism rather than
mathematical expectations, whether moral or hedonistic or
economic. Most, probably, of our decisions to do something positive, the
full consequences of which will be drawn out over many days to come,
can only be taken as the result of animal spirits—a spontaneous urge to
action rather than inaction, and not as the outcome of a weighted
average of quantitative benefits multiplied by quantitative
probabilities." - John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.
In similar fashion
to the Cantillon Effects, which led to the Austrian Business Cycle
Theory and the role of "exogenous" money, Keynes held the view that
"animal spirits" lead to damaging speculation and he was a proponent for
government restrictions on investment to avoid the formation of "asset
bubbles".
But, the "behavioral psychologist" in us would argue that large
speculative episodes throughout histories are not engendered solely by
human nature. Multiple examples of boom, and bust cycles have shown that
the "Cantillon Effects" leading to the formation of asset bubbles
shared common trait of "stimulation". For instance the housing bubble in
the US was clearly the result of government policy in conjunction with
increases in the money of supply with incorrect interest rate levels
leading to speculation and "mis-allocation" of capital.
In similar fashion, as we argued
recently, the effect of the last few years of ZIRP has led to
speculative inflows in Emerging Markets. Current outflows are due to
"flows" issues rather than "stocks" issues (debt levels in many Emerging
Markets remain well below Developed Markets), confirming therefore our
"reverse osmosis" theory.
We did give an early warning on the risk for Emerging Markets on the 14th of April in our conversation "The Night of the Yield Hunter" though:
"The risk of a deflationary bust
validates our negative stance towards commodities and emerging markets
as indicated last week for the second quarter.
In similar fashion UBS in their March 2012 note entitled "The Ides of
March" made an interesting point which could validate the on-going
weakness in both commodities and Emerging Markets:
"The end of Federal Reserve and European
Central Bank (ECB) stimuli will cause an acceleration of capital flows
out of emerging markets, hitting commodity demand." - source UBS
The work done by Didier Sornette's team relating to the prediction of the formation of asset bubbles as indicated on the "Financial Crisis Observatory" site clearly illustrates the "Cantillon Effects" at play.
For instance their recent study of the "behavior" and bubble formation
for Tesla's share price is also illustrative of "bubble formation" and
"animal spirits" or when "our positive activities depend on spontaneous
optimism rather than mathematical expectations", to quote Keynes:
"Inflated high-tech stocks like Tesla (or LinkedIn) are particularly vulnerable during a global correction in stock markets.
Without judging the value of Tesla’s technology, innovation and management, it is a textbook example of a bubble.
See this paragraph from our recent
article D. Sornette and P. Cauwels The Illusion of the Perpetual Money
Machine, Notenstein Academy White Paper Series (Dec. 2012)
(http://arxiv.org/abs/1212.2833 and http://ssrn.com/abstract=2191509)
(https://www.notenstein.ch/sites/default/files/publications/notenstein_white_paper_series_041212.pdf)
“First, a novel opportunity arises. This can be a ground-breaking technology or the access to a new market. An
initial strong demand from first-mover smart money leads to a first
price appreciation. This often goes together with an expansion of
credit, which further pushes prices up. Attracted by the prospect of
higher returns, less sophisticated investors then enter the market. At
that point, the demand goes up as the price increases, and the price
goes up as the demand increases. This is the hallmark of a positive
feedback mechanism. The behavior of the market no longer reflects any
real underlying value and a bubble is born. The price
increases faster and faster in a vicious circle with spells of
short-lived panics until, at some point, investors start realizing that
the process is not sustainable and the market collapses in a
synchronization of sale orders. The crash occurs because the market has
entered an unstable phase. Like a ruler held up vertically on your
finger, any small disturbance could have triggered the fall.”
It is also important to stress that in the same manner Tesla is the
textbook example of the importance of bubbles in innovation and
technological revolutions, as explained within our "social bubble'"
hypothesis [1-4].
If you look at the income statement
of Tesla you see that the company has been losing money consequently.
This is no surprise for such a high-tech startup.
If investors would only focus on fundamental value, Tesla would not be able to raise money through the stock-market. However, because
of the anticipations, hence, the bubble effect on the price, investors
are nevertheless attracted by expected profits. This would not be
possible if the price would be fully fundamentally driven." - source ETH, Financial Crisis Observatory.
Tesla Market value exceeded $20 billion on the 26th of August - graph source Bloomberg:
There you go, "spontaneous optimism rather than mathematical expectations" to paraphrase Keynes.
The Log-Periodic Power Law Oscillations (LPPL), is part of the
methodology used by Professor Sornette to ascertain the "bubble" level (here comes the notion of fractals and our prior reference to Mandelbrot and his book The (Mis)Behaviors of Markets).
Of course, another illustration of "Cantillon Effects", credit creation
and "bubbles", as we have long ascertained, has been in the shipping
industry as illustrated by the "boom" and "bust" of the Baltic Dry
Index.
The Baltic Dry Index aggregates the costs of moving freight via 23
seaborne shipping routes. It covers the movement of dry-bulk
commodities, such as iron ore, coal, grain, bauxite and alumina.
In similar fashion the burst of the credit bubble had a dramatic impact
on housing, shipping was as well not spared as cheap credit did indeed
fuel a bubble of epic proportion - graph source Bloomberg:
"The dry-bulk market, which accounts for about 50% of shipped
freight, is driven by steel demand, as iron ore and coking coal make up
about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate
are also major dry-bulk commodities. The Baltic Dry Index, a major
barometer for the industry, has more than doubled ytd." - source Bloomberg.
The deflationary environment, and "Schumpeter" like creative destruction
has enabled innovation, in the container shipping space benefiting, the
fittest to survive such as Danish Maersk currently busy upgrading
massively its container fleet. Maersk remains our favorite, when it
comes to identifying the survivors in this game of "survival of the
fittest" but we digress.
As we indicated in our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":
"If there is a genuine recovery in housing driven by consumer
confidence leading to consumer spending, one would expect a significant
rebound in the Baltic Dry Index given that containerized traffic is
dominated by the shipping of consumer products."
We have indeed seen such a rebound in the Baltic Dry Index - graph source Bloomberg:
"Containerized traffic is dominated by the shipment of consumer products, and a resurgence in international volumes is dependent on the housing market. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia. Furniture demand has been picking up, after bottoming in 2009 following the collapse of the housing market." - source Bloomberg.
As far as the Baltic Dry Index is concerned, while US Family Housing
Starts looks fairly flat, US Furniture sales have indeed been very
strong explaining therefore the pick-up in the aformentioned Baltic Dry
Index:
Since 2006:
- in yellow the Baltic Dry Index,
- in orange US Family Housing Starts
- in white US Furnitures Sales.
The "Cantillon Effects" of cheap credit led to an inflation of both the
housing bubble and the baltic dry bubble. The increase of US demand led
to an increase in Chinese production, and a rise in commodities prices.
In similar fashion, we indicated the "Cantillon Effects" of QE2 has been exporting inflation in our conversation "Misstra Know-it-all":
"The Fed tried to increase jobs by lowering interest rates, weakening
the dollar in the process, boosting exports but exporting inflation on a
global scale, particularly in the commodities space, leading to
political instability in the process with QE 2. The effect QE 2 has had
on the commodity sphere has been well described in a Bank of Japan
research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.
Like we said about "positive correlations", "Misstra Know-it'all" has
indeed played a quick hand, lifting stock prices, playing on the wealth
effect game and exporting "hot money" flows in Emerging Markets."
When it comes to inflation, the "Cantillon Effects" are another way of
looking at inflationary pressures, but of different nature. Inflationary
pressures are not always strictly tied up to consumer prices, but, can
be transmitted first in asset prices. While inflation in the US peaked
at 5.6% in August 2008 prior to the stock market crash of October, the
"Cantillon Effects" witnessed in the surge of assets prices were largely
ignored by the US central bank - graph source Trading Economics:
As far as markets are concerned and in respect to the current level of
prices, whereas market's performance in the 5 years that followed the
demise of Lehman Brothers has been stellar, we agree with Bank of
America Merrill Lynch's recent note entitled "Tinker, Taper, Told Ya,
Buy" from the 12th of September, the next 5 years will probably be more
"problematic"
"Asset markets will not do as well in the next 5 years, no matter what “nouveau bulls” say. Central banks will be less generous, corporations less selfish. And should excess liquidity be quickly removed markets will get “CRASHy”." - source Bank of America Merrill Lynch
Truth is the big beneficiary of the "Cantillon Effects" in the reflation
game played out by the Fed has indeed been Wall Street versus Main
street as indicated by Bank of America Merrill Lynch in the same note:
"After Lehman…
An unprecedented financial and economic crisis, crystallized by the September 15th 2008 bankruptcy of Lehman Brothers, was followed by an unprecedented monetary policy response, which in turn has been followed by unprecedented bull markets in bonds, stocks and now real estate. Wall Street has soared, but Main Street has soured (Chart 2). The exceptional “sweet spot” engendered by generous central banks and selfish corporations has been great for owners of capital, but bad for labor.
The "race to reflate" in the developed world and faltering Chinese macro leadership dictated the winners & losers of the past 5 years: Gold, High Yield, EM debt & Asian equities have been big winners; Commodities, Government Bonds & Japanese equities have been the big losers (see Table 1 on front page).
QE was the prime driver of the ‘09 trough in stocks & the ‘11 trough in real estate, and liquidity withdrawal has driven the jump in global interest rates in 2013. A further rapid, jump in rates would destabilize asset markets, but this threat remains low in coming quarters. The 100 basis point summer surge in the 30-year Treasury yield has tethered the S&P500 index to a tight 1600-1700 range and traumatized many fixed income & emerging markets." - source Bank of America Merrill Lynch
So if markets, does indeed become crashy in the next five years, we suggest you check, once in a while the bubble index blog:
On a final note, if indeed rates are for
"normalization", in similar effect, the world is "normalization" as
well given the Syrian crisis has seen the return of the Russia to world
center stage, making us believe into a new era of "bipolarization".
Market wise, we believe as well the Russian ruble is poised for a
rebound as indicated by Bloomberg Chart of the Day:
"The ruble is poised to rebound from a four-year low as oil’s climb to the highest since February lures investors who fled during an emerging-market selloff after the Federal Reserve said it would taper economic stimulus.
The CHART OF THE DAY shows the currency of Russia, the world’s biggest oil producer, tumbling to its weakest since August 2009 against the central bank’s dollar-euro basket, even as Brent crude futures rallied to $117.34 a barrel last month. Previously the ruble had largely kept pace with changes in the price of crude, the country’s main export earner.
About $24 billion has been taken from emerging-market bond funds since the end of May, OAO Gazprombank and Morgan Stanley said, citing EPFR Global data. That’s the same month Fed Chairman Ben S. Bernanke first said U.S. policy makers were contemplating reducing quantitative easing.
“For the past few months, the market has been fixated on the Fed,” said Dmitry Dorofeev, a trader and strategist at BCS Financial Group in Moscow. “The ruble’s relationship with oil should re-establish itself once the initial taper is out of the way, and we should get a nice bounce.”
The ruble also may recover as energy exports climb from seasonal lows and local demand for foreign currency declines after annual dividend payments by large Russian companies and the peak of the tourist season, Dorofeev said. Russia is the world’s biggest supplier of natural gas and the No. 2 oil exporter, according to the International Energy Agency. The ruble has dropped 7 percent against the dollar and 7.8 percent against the euro this year, on track for its worst annual performance since the 2008 financial crisis." - source Bloomberg
"If liberty means anything at all, it means the right to tell people what they do not want to hear." - George Orwell
Saturday, 7 September 2013
Credit - The tourist trap
"Employ your time in improving yourself by other men's writings, so
that you shall gain easily what others have labored hard for." - Socrates
Looking at the continuous outflows from Emerging Markets funds and in
continuation of our recent title analogies relating to the "reverse
osmosis" thesis, we thought this time around we would use a simpler
analogy in our title reference namely the colloquial "tourist trap". As
per the definition of a "tourist trap", a tourist trap is an
establishment, or group of establishments, that has been created or
re-purposed with the aim of "attracting tourists" and their money.
Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets.
Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets.
In our case, Ben's "tourist trap" involved ZIRP, low volatility and high
carry trades in Emerging Markets currencies which, for many years, had
the favors of Japanese retail investors in the form of the
"double-deckers" (the famous Uridashi funds which particularly favored
the Brazilian real).
Of course if Bernanke is serious about initiating his "tap dancing"
following "twist", this might spell out the "last tango" for Emerging
Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
If the Fed starts draining liquidity, some "big whales" might turn up
belly up. Could it be Chinese banks defaulting? Emerging Markets
countries defaulting as well due to lack of access to US dollars?"
"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.
So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).
A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:
- graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics.
Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:
"India’s record foreign debt threatens to undermine the government’s
plan to halt the rupee’s biggest slide in more than 20 years by reining
in the budget and current-account deficits.
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.”
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.
All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.
And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:
We recently added JP Morgan Emerging Markets Currencies Volatility Index
to our graph to display the on-going effect US Treasury volatility has
on Emerging Market currencies.
With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg
Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.
When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three
sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we
are witnessing three sisters rogue waves in our European crisis,
namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis
"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.
So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).
A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:
Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.”
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.
All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.
And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market
currencies. The index is based on three-month at-the-money forward
options, weighted by market turnover.
With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg
Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.
When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:
Of course some would argue that this "Great Rotation" story from bonds to equities, as far as flows are concerned, has been playing out in earnest in 2013 as displayed in Nomura's recent report:
So far, so right...but, if one looks at the inflows into bonds versus equities since 2010, then the "Great Rotation" story does seem much ado about nothing as displayed once more in Nomura's recent chart:
In fact, what seems to be happening, when it comes to "Great Rotation" for equities is a rotation out of equities except for European equities according to Nomura:
"Equity and bond funds both suffered outflows last week with USD 11bn redemptions from equity funds and a small net outflow of USD 0.8bn from bond funds according to EPFR. Money market funds also saw net sales totalling USD 7.5bn last week. Both developed market and emerging market equity funds suffered net selling and European funds once again outperformed, being the only region that we track to have received net inflows last week. Our global composite flows based equity sentiment indicator has oscillated fairly tightly around 1 standard deviation over the most recent eight weeks and last week dropped marginally to 0.97 standard deviations, a reading that we would consider as bullish but just below extended levels.
-US fund investors sold USD 5bn from equity funds last week. Over the past three weeks they have withdrawn a total net USD 15bn from equity funds, reversing only a fraction of the net USD 141bn invested into equity funds in the 33 weeks of the year to 14 August, according to the Lipper weekly reported dataset. Our US flows based indicator continued to moderate last week and now reads 0.7 standard deviations, signalling moderately bullish sentiment in our view.
-European equity funds bucked the global selling trend as they attracted an additional USD 0.8bn of net inflows last week. This is the 10th consecutive week of net inflows into European equity funds, a major reversal from the persistent selling seen in recent years. However, last week's inflow showed a moderation in the magnitude of money flowing recently into European equity funds. Consequently, our European flows based equity sentiment indicator was unchanged over the week at 2.24 standard deviations but remains close to the historical bullish extremes of sentiment measured over the past nine years.
-Emerging market equity investors continued selling equity funds last week with an additional net USD 2.8bn outflow from GEM equity funds. Although last week's outflow was the most significant since the end of June, our GEM sentiment indicator rose to -1.4 standard deviation but still reflects very depressed sentiment towards EM equities. Furthermore, investors continued to exit from the dedicated regional EM equity funds with net outflows of USD 1.1bn from Asia ex Japan funds, USD 0.1bn from LatAm funds and the highest weekly outflow (USD 0.5bn) from emerging EMEA funds in almost two years." - source Nomura.
"Great Rotation" or "Great Escape" you decide, given Bank of America Merrill Lynch also indicated on a note from the 5th of September entitled "EM Pain trade is up" the following:
Big weekly equity redemptions of $11.4bn. Past 3 weeks equity outflow of $29bn largest in 2 years (Chart 1).
Inflows to Treasury funds this week despite historic sell-off. Follows 8 weeks of redemptions. Suggests onset of smart short-covering in recent days. Blowout payroll required for clean immediate break of 2%, 3%, 4% levels by 5, 10, 30-year Treasury respectively. No jobs blowout...look for reversals in recent sell-offs in bonds and EM." - source Bank of America Merrill Lynch.
Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014.
Why so?
Because of tightening financial conditions, particular in China following a massive credit growth, which will impact bank lending behavior in a negative way. China is increasing the clampdown on credit and on industrial overcapacity. Given banks are always a leverage play on economic growth, despite record profits at China's largest banks, stock valuations are not benefiting from this surge given the significant rise in nonperforming loans as displayed in the below Bloomberg graph:
Default risk is rising in the world’s second-largest economy, which economists forecast will grow this year at the slowest pace in 23 years. The government has been clamping down on excess capacity in industries including steel and cement as it tries to transition to a more sustainable economic growth model based on consumption rather than export-driven production." - source Bloomberg.
The delicate rebalancing act for the Chinese economy is in fact being put at risk by the aggressive "tapering" stance at the Fed as indicated by Chinese Vice Finance Minister Zhu Guangyao comments at the G20 as reported by Bloomberg:
"The U.S. should be mindful of a possible “very significant spillover effect,” said Zhu, who called for greater coordination between nations and added that there’s no need for a rescue plan for developing countries."
He also added:
“Some emerging-market economies are facing difficulties,” Zhu said. “Capital is flowing out of these countries and their currencies are under pressure of depreciation, and the major direct cause of such a phenomenon is the Fed’s announcement that it may exit its unconventional monetary policy. However, on the other hand, there are some structural problems with these emerging market economies as well.” - source Bloomberg, "China Asks U.S. to Cap QE Exit Risk as Indonesia Warns of Impact"
Therefore the impact of a tightening credit channel in China means more pain for the current account of countries exporting to China (including Germany), given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.
The tightening credit channel in China and the clampdown on overcapacity will of course hurt Germany.
These were our concluding remarks in our recent conversation "Fears for Tears":
"The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008"
-Output, adjusted for seasonal swings, fell 1.7 percent from June, when it jumped a revised 2 percent, the Economy Ministry in Berlin said on the 6th of September when economists were only expecting a decline of 0.5%.
-German exports, adjusted for working days and seasonal changes, fell 1.1 percent in July from the prior month, the Federal Statistics Office in Wiesbaden. Economists predicted an increase of 0.7 percent in a Bloomberg News survey.
On the impact of current account for countries exporting to China, we agree with our friends at Rcube Global Macro Asset Management:
"Current account of countries exporting to China are turning negative (and will remain so as long as China tighten its flow of credit). FX reserves’ pace of accumulation reverse and with them a host of asset prices that have been tightly correlated with it over the last decade: domestic real estate and equity prices, private consumption, commodity prices etc…"
So, due to our Pareto efficient economic allocation, the weakness in Emerging Market equities, which have been simply the victims of currency wars and "Abenomics" mostly, (see our post "Have Emerging Equities been the victims of currency wars?"), will continue further, because the "reverse osmosis" occurring in Emerging Markets as displayed by "funds allocation" is positively correlated to US real rates moving into positive territory, or put it simply, when the risk doesn't match the reward anymore.
The velocity in the "allocation" is entirely due of course to the speed of rising yields in developed countries as displayed in the chart below from Thomson Reuters Datastream / Fathom Consulting displaying by how many basis points 10 year yields have risen since the 30th of April:
- graph source Thomson Reuters Datastream / Fathom Consulting:
On a side note, those who piled into Apple 30 years, part of their $17 billion bond auctioned on the 30th of April are probably still licking their wounds given these bonds are currently trading around 83 in cash price...But, don't despair, you might get a "second chance" with Verizon which plans a record $25 billion debt offering as it gathers financing to buy Vodafone’s stake in their Verizon Wireless joint venture...
Moving on to our own "Forward Guidance", as we enter the statistically dangerous month of September, some additional signs in the markets, apart from "tapering" noise, Syrian issues, European political jitters in Italy and Emerging Markets tantrums, can be seen in the currency market according to our Rcube friends, in particular in the AUDCHF currency pair:
"The world’s economic momentum is slowing not accelerating, as evidenced by the AUDCHF:
As a result, the AUDCHF usually weakens when global growth economic momentum slows down and/or when financial stress kicks in. When the two happen at the same time (1998, 2001, 2008, 2011) the move is all the more violent.
Today, the AUD is weakening because of the EM slowdown, but more recently the CHF has strengthened on its own, probably on the back of rising risk aversion due to the FED tapering anxieties (EURCHF peaked on May 22nd)." - source Rcube Global Macro Asset Management
And if you think that the "reverse osmosis" plaguing Emerging Markets has touched a bottom, think again because as our Rcube friends put it, regardless of the incoming chatter surrounding the "debt ceiling" debate, budget balances do matter, but the US budget balance, when it comes to Emerging Markets, it matters A LOT:
"Additionally, the US budget balance is improving faster than at any time in history. In the past this has been associated with a tighter liquidity environment (fewer dollars in circulation) which was particularly negative for emerging markets. As shown in the chart below, when the budget balance improves (deviation from 2yr trend goes up), emerging markets underperform DM equities, and inversely. Given the current expectation for the budget deficit to shrink further (‐2% of GDP in 2015 vs. ‐4.6% today), the relationship will remain negative for EM equities in the foreseeable future."
- source Rcube Global Macro Asset Management
On a final note, we would like to provide you with another "out of the box" interesting indicator we follow namely Sotheby's stock price versus World PMIs since 2007 - graph source Bloomberg:
The recent stellar performance of the art market in general and Sotheby's in particular can also be partly explained by the flood of global liquidity provided by our "omnipotent" central banker at the Fed. Art markets and economic growth tend to be positively correlated we think.
And, when it comes to providing "liquidity" and market backstop, rest assured that Sotheby's has been as involved as any central bank, given it has started again into auction guarantees totaling $166.4 million in a move aimed at winning more consignments. But, more recently the New York-based auction house said last night it’s reducing its exposure by “irrevocable bids” of $23.5 million, which are from undisclosed third-party guarantors. It may further reduce risk by additional “irrevocable bids” before auctions in the fourth quarter, it said in the filing with the U.S. Securities and Exchange Commission as reported by Bloomberg.
Looks like even auction houses are preparing for "tapering"...
Oh well...
So move along, no risk of financial crisis:
“The probability of it happening again in our lifetime is as close to zero as I could imagine"
“The way these firms are managed, the amount of capital that they have, the amount of liquidity that they have, the changes in their business mix -- it’s dramatic.”
“The largest financial institutions in the U.S. are as healthy now as they have ever been,”
“There’s a difference between incompetence or mismanagement or poor judgment or excessive risk taking from actually breaking the law,”
“There’s nothing I’ve seen that would suggest that any of the major participants in the financial crisis should be in jail for their actions.”
- Morgan Stanley Chief Executive Officer James Gorman, on the Charlie Rose show.
Stay tuned!